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Putting Chinese Financial Reform in Perspective

That seems to be China’s motto when it comes to financial reform. Officials have launched several initiatives to boost lending to private entrepreneurs and small- and mid-sized businesses (SME) in recent years, but none have helped much. So now, they’re trying again. Last month, the State Council announced plans to develop private banks, claiming the influx of private capital in the banking industry would flow to SMEs. And maybe it will! But because the plan lacks specifics, it’s unclear whether it will succeed where its predecessors failed. This is just the latest example of the challenges China faces in modernizing its financial system—how officials tackle this and other issues will be key to the country’s future economic growth and capital markets prowess.

For years, Chinese SMEs have had trouble getting funding. Banks finance most Chinese businesses, but 9 of the 10 biggest banks are state-run, and they lend predominantly to state-run firms—which have an implicit government guarantee. SMEs, seen as too risky, are largely shut out. But SMEs also tend to be more profitable than state-run firms and are widely considered China’s future growth engine, provided they can get the capital they need.
So the government has spent years tweaking the financial system in an effort to support them—but the changes haven’t gone far enough. For example, in 2008, officials legalized microcredit—but tied lenders’ hands with myriad restrictions. Regulators prohibited microlenders from accepting deposits, so they have to borrow capital from the banks—which won’t extend much credit. So China’s 5,629 microlenders can’t even begin to fill the SME funding shortfall.

In March 2012, with growth slowing nationwide, officials took a new approach. In the coastal city of Wenzhou—a longtime private-sector hub—they launched a pilot program to legitimize and regulate private financing. Many entrepreneurs and SMEs already receive private loans, but it’s underground—dominated by loan sharks charging usurious rates and using other nefarious tactics. By legalizing private lending, officials thought they could drive the hucksters out of business and goose SME lending in one fell swoop. Yet not much changed—few people used the government’s new “private lending center,” and business leaders say the lending environment is worse now. It isn’t hard to see why the changes haven’t worked. Officials declared private lending legal in principle, but they seemingly forgot to define it. The rules were unclear, the new system lacked legal support, and financing stayed underground (and regional GDP growth slowed to 6.7%, well behind the national tally).

The problem? Without clear definitions and rules, those who borrow from private lenders risk being convicted for “illegal fundraising,” which is a crime punishable by death. Since 2011, around 1,500 people have been sentenced to five-plus years in prison (or death) for this. According to China’s supreme court, individuals may be guilty if they receive more than 200,000 yuan ($32,000) in private loans or cause their lenders to lose 100,000 yuan ($16,000). For businesses, those thresholds rise to 1 million yuan ($160,000) and 2.5 million yuan ($400,000), respectively.

The law’s apparent intent is to deter and punish China’s Bernie Madoffs, and it’s likely some genuine fraudsters have been convicted. But the definition of fraud looks an awful lot like the definitions of legitimate fundraising and simple business failure, and legitimate businesspeople have been convicted, too. The most high-profile example, retail tycoon Wu Ying, was sentenced to death in 2009 after her empire of beauty salons, drycleaners, karaoke bars and other endeavors went bust, causing her creditors to take hefty losses. According to Chinese authorities, she “brought huge losses to the nation and people with her severe crimes, and should therefore be thoroughly punished.” Wu rejected accusations of swindling—this wasn’t a Ponzi scheme. She invested the funds in actual business ventures, and to civilized observers, her only sin was overextending a shaky business model. Yes, she relied on private creditors, but considering they demanded higher interest rates as her business wobbled, it seems they knew the risks. In a well-functioning capitalist system, this would go down as a simple business failure, creditors would write off losses, and Wu would only lose money (and some face). In China, however, until the court commuted Wu’s sentence to life in prison last month, she faced death.

This and other similar stories have largely scared Wenzhou businesspeople from taking advantage of last year’s reforms. Officials seem to realize this, and in their first-year review of the Wenzhou program, they pledged to fix matters so the program could succeed and go national. Yet plans were sketchy—aside, that is, from draft legislation to establish a new agency that would document all loans and track borrowers’ credit ratings, credit card purchase history and loan repayment records. Now, if this information were tracked by a private company in a country with a transparent legal system, it would seem innocuous enough. But in China, with a government bureau keeping these records, it’s likely a treasure trove of evidence for any future “illegal fundraising” prosecutions, legitimate or not. That likely doesn’t attract a ton of borrowers or lenders, especially when the government remains committed to cracking down. Unless, that is, the line between illegal fundraising and legitimate private lending gets clearer.

Because China’s track record of financial reform is so shaky, it seems difficult to get too jazzed over its latest plans. Yes, more private banks would be great! But because the government hasn’t released a time table or clarified the process for starting a bank, there is no way to know if the plans will work. Right now, no one knows what the process for getting a banking license will be—who will be eligible, which hoops they’ll have to jump through, how much capital they’ll have to front or whether there will be arbitrary limits on competition. No one knows what the funding and capital requirements will be—will private banks be allowed to set their own deposit rates? Raise funds on wholesale markets? Conduct private trading and investment banking activities to help manage risk so they can lend more enthusiastically?

Simply, there are too many questions. And combined with the lingering questions over the Wenzhou reforms, the fate of private lending in China seems up in the air. Should officials see both schemes through and move to a truly market-oriented financial system, China would likely benefit tremendously over time. Well-funded entrepreneurs and SMEs would support growth and provide new investment opportunities, and China’s capital markets would likely be much more attractive on the international stage. Thus, how these and other reforms progress—whether action follows grand statements—will likely be an important driver of Chinese equity returns.

This constitutes the views, opinions and commentary of the author as of August 2013 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. No assurances are made regarding the accuracy of any forecast made. Past performance is no guarantee of future results. Investing in stock markets involves the risk of loss.

By Elisabeth Dellinger

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